Get Real: Interpreting Nominal Exchange Rate Fluctuations

This paper derives a structural relationship between the nominal exchange rate, national price levels, and observed yields on long-maturity inflation-indexed bonds. This relationship can be interpreted as defining the (conditional) risk-neutral fair value of the exchange rate between two countries in which inflation-indexed bonds are issued. We derive a novel, empirically observable measure of the risk premium that can open up a wedge between the observed level of the nominal exchange rate and its risk-neutral fair value. We relate our measure of the risk premium reflected in the level of the nominal exchange rate to the familiar Fama measure of the risk premium reflected in rates of return on foreign currency investments. We take our theory to a data set spanning the period January 2001-February 2011 and study high-frequency, real-time decompositions of pound, euro, and yen exchange rates into their risk-neutral fair value and risk premium components. The relative importance of these two factors varies depending on the subsample studied. However, subsamples in which, contrary to the Meese-Rogoff (1983) puzzle, 30 to 60 percent of the fluctuations in daily exchange rate changes are explained by contemporaneous changes in risk-neutral fair value are not uncommon.